Markets - Credit - A Deficit Target Too Far

"I think we may be going a bridge too far."
British Lieutenant-General Frederick Browning, deputy commander of the First Allied Airborne Army to Field Marshal Bernard Montgomery

Our title follows up on our previous conversation "All Quiet on the Western Front", where we discussed our BIG reservations relating to the unachievable Spanish deficit target of 3% in 2013. This week's analogy refers to the overly ambitious Operation Market Garden of September 1944 in relation to the overly ambitious deficit targets set up by European leaders for Spain. It wasn't really a surprise to see Italy today following the footsteps of Spain and revising its budget deficit target for 2013 from 0.1% to 0.5%. They have as well revised their 2012 GDP contraction from 0.5% to 1.2% with a GDP growth target of 0.5% for 2013. Oh well...Initially, Operation Market Garden was marginally successful and several bridges between Eindhoven and Nijmegen were captured. However, General Horrocks' XXX Corps ground force's advance was delayed by the demolition of a bridge over the Wilhelmina Canal, as well as an extremely overstretched supply line (ESM and EFSF firepower are overstretched as far as Spain and Italy are concerned)...a bridge too far, and certainly a deficit target too for Spain, but here we go, we ramble again. Before we revisit the overly ambitious plan for Spain, and review France as the new barometer of Euro Risk with the upcoming first round of the presidential elections, it is time for our usual credit market overview.

The Credit Indices Itraxx overview - Source Bloomberg:

Since last the last rebalancing of credit indices on the 20th of March, Itraxx Credit indices have been overall wider, with SOVx Western Europe 5 year CDS index (representing CDS of 15 European countries, with Cyprus replacing Greece since its "selective default") wider by 26%.  Itraxx Crossover 5 year CDS index (High Yield risk gauge - 50 European companies) was wider by 12.5 bps in the early afternoon, 125 bps wider since the roll date of the 20th of March.

Itraxx Crossover has been rising and Eurostoxx Volatility is rising to 23.45 - source Bloomberg:

The "Flight to quality" picture as indicated by Germany's 10 year Government bond yields (well below 2% yield) is still pointing towards the lowest level reached in 2011, around 1.73% - source Bloomberg:

A game of capital preservation rather than a search for yield for European investors.

The current European bond picture with the recent rise in Spanish and Italian yields - source Bloomberg:

As indicated by CreditSights in their recent note - Eurozone - Recycling ECB Reserves in Italy and Spain on the 17th of April, LTRO 1 and LTRO 2 have enabled Spanish and Italian banks to soak up domestic bonds:

"The ECB’s provisions of liquidity to Italian and Spanish banks have partly been used by those banks to increase their holdings of domestic government bonds.

Spanish and Italian banks have increased their holdings by 41 billion euro and 19 billion euro between the end of November and the end of January following the first three year LTRO. That increase in holdings by domestic banks has coincided with a dramatic decline in foreign holdings of those two countries’ government bonds. The result is an increase in concentration of government bond holdings within those two countries banks."

Given recent developments in revised deficit target objectives for both Italy and Spain, as well as the significant widening in credit spreads (Itraxx Financial Senior index indicating a rise in financial risk) and tightening of "safe haven" German bund, we would advise caution. In fact we have seen this movie before, so clearly "Mind the Gap" - source Bloomberg:

In fact Europe's volatility index V2X is well above VIX index and the divergence between both has been rising - source Bloomberg:

The liquidity picture, as per our four charts, ECB Overnight Facility, Euro 3 months Libor OIS spread, Itraxx Financial Senior 5 year index, Euro-USD basis swaps level - source Bloomberg:

While liquidity conditions have seriously improved since the end of 2011, thanks to the ECB's two rounds of LTRO, the LTRO "alkaloid" effect is somewhat fading hence the renewed tensions seen on the Itraxx Financial Senior Index indicating a deterioration in one of these indicators. According to Nomura in their report "Wilting growth and sovereign and bank pressures" from the 10th of April:

"Other areas of the funding markets are increasingly showing signs of stress, including the EUR-USD cross currency basis swap. This has been compressing across the tenors, primarily due to the Fed swap line, which was put in place in November 2011, but also due to lower volumes going through these markets given the unwind in USD operations by some banks leading to reduced USD funding through these sources. We could see a continuation of this renewed widening as tensions increase in the euro area."

Moving back to the subject of the overly ambitious deficit reduction plan for Spain in true Market Garden style, a recent report published by Exane BNP Paribas strikes a blow to the plan in a less courteous manner than British Lieutenant-General Frederick Browning : "Are deficit targets credible? In short no"

Exane BNP Paribas believes the GDP Growth for Spain will only amount to -1.1% versus an official estimated growth of 2.4% in 2013, leading to a budget deficit of -5.6%  in 2013 versus the overly optimistic objective of -3% discussed in the conclusion of our previous conversation. Clearly "A Deficit Target Too Far".

Exane BNP Paribas in their note convey several reasons for their estimate:
"Collapse in tax receipts puts additional pressure on spending cuts" - Source Exane BNP Paribas - Eurostat:

Regions account for 50% of spending in Spain - Source Exane BNP Paribas - OECD:

"-45% of Regions' spending goes to health and education - tough to cut.
-Regional governments missed targets significantly in 2011; targets for 2012 are too ambitious".
- Exane BNP Paribas

In their note Exane BNP Paribas is going further, public confidence in the government is waning, as indicated by recent polls from Spanish newspaper El Pais:

When austerity bites with high youth unemployment, risks of social stability are mounting, which could potentially lead to a European Autumn in similar fashion to the Arab Spring?

As far as credit flows to the real economy are concerned, the potential problematic loans currently sitting on Spanish banks balance sheet will undoubtedly weight heavily on economic growth in the near term as indicated by the latest rise in Non-performing loans to 8.16 percent in February according to the Bank of Spain, its highest level since 1994.

"Current consensus for 2012 Spanish GDP is for a contraction of 1.2%. As the government attempts to realize 37 billion euros of austerity savings, this figure may well increase unemployment and drive consumer spending lower. Santander's FY11 Spanish NPL ratio was 5.5%, with real estate loans at 28.6%. Lower GDP could drive these figures higher." - source Bloomberg

In fact according to Bloomberg Chart of the Day from the 17th of April, Spanish Mortgage Defaults may double on joblessness:

"The CHART OF THE DAY shows that unemployment was 24.5 percent when the mortgage default rate peaked at 5.5 percent in 1994. Even as the jobless rate rose to 23.6 percent this month, defaults are half as high at 2.7 percent." - source Bloomberg

European Subprime in the making? (we wondered in our last conversation), US Mortgage delinquencies peaked at 11.2% according to Bloomberg, Spain has yet to rise to these levels:

"Banesto, Santander's domestic subsidiary, revealed the percentage of problematic property loans had risen above 50% by 1Q, from 32% 12 months earlier. In February, the Bank of Spain announced 35 billion euros of provisions and 15 billion of capital to clean banks' balance sheets. These measures may be revisited should deterioration continue." - source Bloomberg

On a final note, we previously discussed at length France's "Grand Illusion", and France is clearly moving to center stage.
As indicated by Cheuvreux in their recent Cross Asset Research from the 16th of April:
"Spain is the 2012 epicenter of EZ financial stress. The return of pressures upon the vulnerable compartments of the EZ equity universe has been remarkably rapid even by the standards of the recent past because so many have been waiting for this accident to happen. The French election acts as a further accelerator."

We also believe France should be seen as the new barometer of Euro Risk with the upcoming first round of the presidential elections. French CDS were driven wider today with apparently some heavy buying of CDS protection from real money accounts and Hedge Funds according to market makers in the French CDS space - source CMA

Whoever is elected, Sarkozy or Hollande, both ambition to bring back the budget deficit to 3% in 2013 similar to their Spanish neighbor. We think it is as well "A Deficit Target Too Far" on the basis of our previous French conversation (France's "Grand Illusion").

"Everybody is ambitious. The question is whether he is ambitious to be or ambitious to do."
Jean Monnet - French political economist and diplomat, regarded by many as a chief architect of European Unity.

Stay Tuned!